Political Wisdom: What’s Next for the Financial Overhaul?

By

Mary Lu Carnevale

May 22, 2010 6:00 am ET

The Senate’s approval of the sweeping financial regulation overhaul left lawmakers and lobbyists looking toward the process of ironing out differences with a similar house bill. And it left others looking at whether the bill would accomplish what it set out to do: prevent a repeat of the financial crisis, the regulatory confusion that followed and the big expenditure of federal funds to prop up failing companies.

The answer is: “Sorta,” but not quite in the way the bill’s supporters suggest.

The gist of the administration’s attack on the too-big-to-fail (TBTF) problem is a provision known as “resolution authority.” Under the status quo, the government basically has two choices for dealing with a major financial firm on the brink of collapse: It can get out of the way and hope for the best, as it did to disastrous effect with Lehman Brothers. Or the Federal Reserve can float the company a massive loan, as in the case of AIG.

The idea behind resolution authority is to avoid these lousy choices. Under the new law, the government would be able seize the wobbly firm, fire its executives, and fund its operations until it could sell them off in pieces. The proceeds from these sales would pay the government back; whatever was left would go to bondholders, who would presumably suffer some losses. The shareholders—the people who own common stock—would get wiped out entirely. (If the proceeds weren’t enough to repay the government, it would recoup the rest by levying a fee on the industry.) This is basically a scaled up (and stretched out) version of the way the FDIC handles smaller-bank failures.

Long story short, resolution authority is unquestionably an improvement over the status quo. The biggest reason is that the prospect of losses for bondholders mitigates the most pernicious consequence of TBTF: moral hazard. That is, because people who lend money to megabanks assume the government will make them whole if the bank collapses, the lenders have little incentive to rein in excessive risk-taking by the bank’s managers. In fact, they actually encourage it by under-pricing their loans. The threat of being “resolved” by the government should change that calculus.

Daniel Indiviglio at the Atlantic, looks at what’s likely to be in the final bill after the Senate and House work out some significant differences. Top on the list, a “systemic risk regulator.”

A new prudential regulatory council will be created, consisting of the heads of existing regulators, such as the chairs of the Federal Reserve and Federal Deposit Insurance Corporation, the Treasury Secretary, and the Comptroller of Currency. Its job will be to discuss trends in the macroeconomic landscape and try to spot looming market shocks before they hit. Some believe that if such a council had existed prior to the financial crisis, regulators would have had a better chance at spotting the housing bubble and other structural problems that existed in the financial markets. If they had, they might have taking action to prevent some of the destruction that resulted…